As many readers will know, the US Securities and Exchange Commission passed a new “hedge fund” anti-fraud rule on July 11. We have poked fun of it a few times – including in the most recent edition of our “Alpha Digest” email update – because of its apparent redundancy. It seems to simply confirm that it remains illegal to break the law.
(If you’re an asset manager and the mere thought of reading another story about hedge fund regulation makes your toes curl, we recommend you forward this posting to your compliance officer. We think it’s definitely worthwhile having someone at your organization check this out.)
Although the rule applies equally to mutual funds, private equity funds and hedge funds (any pooled investment vehicle), the media has emphasized the hedge fund angle with statements like:
“The Securities and Exchange Commission last week to dropped the hammer on hedge fund managers by unanimously voting to adopt a new anti-fraud rule under the Investment Advisers Act.”
and stories like these
- SEC’s New Rules Assert Control Over Hedge Funds
- Closing loophole, SEC says hedge funds can no longer commit fraud on investors
Yes, some media outlets seem to suggest that hedge funds used to be allowed to defraud investors – like it used to be an important and regular part of day-to-day business (!) Furthermore, the rule is aimed at all types of pooled funds, not just hedge funds and the commission itself points out that this arguably redundant rule actually asserts no new “controls” over the activities of pooled fund managers.
Notwithstanding the legal gray area that may have been created by the so-called “Goldstein Decision”, the timing of this rule is politically convenient. By happy coincidence, July 11 was also the date that the SEC testified in front of Congress on the issue of hedge fund IPOs (and by extension, the ensuing financial windfall accruing to the evil hedge fund robber-barons).
Thanks to the US law requiring that nearly every meeting of every agency be open to the public, you can also enjoy over an hour of fascinating debate and witty repartee on the commission’s webcast of the meeting here. But in case you don’t make a habit of following these things (and based on the number of empty seats in the meeting room, it appears this would be most of you), we have reviewed the game footage and provided some of the highlights below…
Among other things, the Goldstein Decision specified that an investment adviser to a pooled fund had a fiduciary responsibility directly to that pooled fund, but not to each of the fund’s underlying investors. As Chairman Christopher Cox pointed out, the new rule requires advisers to “look through” the pooled fund to the underlying investors.
“(This is) a rule that lies at the heart of the commission’s mandate â€“ the protection of investors. The new rule is designed to require that investment advisers look through the hedge funds, mutual funds and other investment vehicles that they advise directly to the investors who entrust their hard-earned dollars to these advisers.
“What gives rise to the need for this rule is a court of appeals decision last year in Goldstein vs. SECA side effect of that decision was to raise the question of whether a hedge fund’s underlying investors are considered to be clients of the hedge funds adviser â€“ and therefore whether the Advisers Act protects them just as it protects other clients of investment advisers who don’t invest through funds.
“The court’s opinion offered us a way to proceed with an appropriate rule that does not require registration but that does prohibit misconductLast December we proposed a rule to clearly prohibit investment advisers who manage hedge funds and other pooled investment vehicles from making false or misleading statements to investors in those funds and from defrauding those investors in other ways.
“The rule applies to advisers of hedge funds. It also applies to advisers of private equity funds, venture capital funds and mutual funds as well.”
Most of the ensuing debate centred around whether the rule was a) too broad and b) redundant. And in the end, the rule was unanimously adopted by the Commission.
While Cox was apparently giddy with excitement, Commissioner Paul Atkins was definitely the least keen – obviously holding his nose as he voted. Commissioners Annette Nazareth and Roel Campos were charter-members of the Rule 206(4) Pep-Squad, while Commissioner Kathleen Casey was somewhere in between, seeming to reserve the right to pull her endorsement if things got ugly down the road.
Several Commissioners argued that the rule simply reinstates the fraud prevention measures in place before the Goldstein decision. But Bob Plaze of the SEC’s Division of Investment Management said there were a few new elements to the rule:
“Unlike Rule 10b5 the conduct prohibited by the rule does not have to be in connection with the purchase and sale of a security. Frauds by investment advisers do not always have to involve securities transactions. Thus the rule would close a current gap in our enforcement authority.”
When asked by Cox exactly what kind of fraud might be captured by this rule that is not already captured by other SEC rules, Plaze said:
“The best and most common we see is the distribution of false account statements or shareholder reports. Those are not necessarily done in connection with the purchase and sales of a security â€“ and they maymisrepresent the value of the assets, the performance of the fund, the risk assumed by the fund and the background of the principals of the investment adviser. Another example is collecting fees that the adviser is not entitled to – defrauding prospective investors by taking their money and absconding without investing it as represented.”
But while this rule may indeed represent a new way to govern the pooled fund industry, Plaze concluded that not much has really changed:
“Readers of the rule will be familiar with the language we have used which is almost identical to many of the commission’s anti-fraud rules that, depending on the circumstances may also be applicableAs a result, the rule incorporates a well-developed body of law that requires participants in securities markets to avoid fraud.
“…the rule does not impose new obligations on advisers to pooled investment vehicles. Before the Goldstein decision, advisers to pooled investment vehicles operated with the understanding that the advisers act prohibits the conduct that this rule prohibits.”
Which begs the question, why have this rule? Atkins, in particular, questioned why the commission needed to reaffirm that it was still illegal to be illegal. Specifically, he reflected the concerns of several of those who commented on the draft, saying that it was too broad to be on any real use:
“I support very much the adoption of a rule like this. We already have many tools that allow us to go after the perpetrators of fraud, but certain types of fraud may fall beyond the reach of existing toolsTherefore, I’m please to support a rule that clarifies our authority and our intention (his emphasis) to pursue this type of fraud.
“The first prong of the rule prohibits misstatements and omissions. It’s similar to rule 10b5 but it is not conditioned on a connection to the purchase or sale of securities. Thus the fund adviser who sends out an account statement that exaggerates the investor’s return would be covered under this rule. This is a reasonable step to take after the decision in Goldstein which correctly overturned our ill-advised hedge fund adviser registration rule. The court correctly reasoned that an adviser cannot owe a fiduciary duty to both a fund and to the investors in a fund. As a result section 206(4) is a better vehicle to use to pursue fraud by advisers against investors in their pools. (his emphasis)
“Now, unlike the first prong of the rule, the second prong doesn’t add much to our arsenal.
“My sons are baseball players and fans and love the rendition of the old Abbott & Costello exchange Who’s on First. This rule reminds me of that skit. It is basically a tautology.
“The statute states that it is unlawful to engage in any act, practice, or course of business, which is fraudulent, deceptive or manipulative. But the problem with our rule is that we’re not prescribing any act, practice or course of business. Instead, we’re simply re-stating the statute.
“(Therefore) the rule makes it a fraudulent, deceptive or manipulative act…to otherwise engage in any act…that is fraudulent, deceptive or manipulative.” It’s like looking up the word mendacity in the dictionary and being told that it means the quality or state of being mendacious. How helpful is that?
“I cannot vote against the truism that is embodied in this rule, but I think I would have preferred a more targeted approach that would have better carried out the mandate given to us by Congressto adopt specific rules. This is what we’ve done up until now. We’ve adopted rules, for example, covering advertisements, custody of client funds, and solicitation.”
Atkins also took issue with the fact that the rule addressed negligence as well actively fraudulent behavior. Apparently several commenters worried that this higher standard would put a “chill” in manager/investor communication.
Further, he worried that the rule’s protection of “prospective investors” was way too broad. He asked who the Commission should include in this group. In reply, Plaze said:
“…people to whom the adviser solicits or otherwise disseminates material. It could be an electronic communication sent to thousands or millions of email addressesBy virtue of avoiding a public offering, advisers have to cabin the information to whom they disseminate. So there would be a natural limitation to whom the fraudulent information is disseminated.
“(However) the fact that the harm does not occur to a prospective investor (e.g. to a creditor) is a defense that an adviser could assert in an enforcement case. The commission would need to make a judgment as to whether the people who received (the information) were mistreated. What we’ve done here is (deliberately) tied the rule to a prospective ‘client'”
Hedge fund managers would be well advised to watch the full webcast to get an idea of what the Commission is aiming to accomplish with this rule. What’s clearly apparent when you see the tape is that this rule is not solely “targeted at hedge funds”, is far from a “hammer on hedge fund managers” and certainly doesn’t “close a loophole” that previously allowed hedge fund managers to commit fraud.